A Basic Fallacy In Business Thinking

There is one theory that dominates how we think the world of business works, which is shared by the field of economics, by politicians and by business people alike, and that is that the market, and with it the world of business, is Darwinian. And therefore, we think, evolutionary processes will assure progress, making business gradually more effective, because Darwinian processes will eliminate bad business practices and strategies through competition.

Unfortunately, though, this conclusion is wrong.

The traditional view

Let me explain. As the New York University Professor Boyan Jovanovic already wrote in the early 1980s, trying to explain the Darwinian nature of markets: “Efficient firms grow and survive; inefficient firms decline and fail.” And he is right. You can bring up a lot of ifs and buts to qualify this view, but on average and in the long run, if you have an economy in which there is competition between firms, some firms will live and others will fail, and efficiency generally will help firms be more competitive and thus live longer.

A Nobel Prize winner in Economics, Douglass North, added: “The implications of the theory are that over time inefficient institutions are weeded out, efficient ones survive, and thus there is a gradual evolution of more efficient forms of economic, political, and social organization.”

The prevailing view is that if the least efficient firms fail, while the efficient ones prosper, the detrimental business practices and strategies that make the former perform so poorly will gradually disappear with them; good business practices, which make firms perform better, will thrive and survive and gradually take over. And thus the world becomes a better place.

The fallacy

What is wrong about this view is not that the world of business is not Darwinian – it is – but the conclusion that we draw from this notion – that detrimental strategies and practices will automatically die out and disappear – is incorrect. The laws of Darwin work as well in business as they do in nature, but our view of how these Darwinian forces play out in the world of business is oversimplified. In fact, it is overly ego-centric.

The basic intuition of why the conclusion is wrong is quite easy to grasp: Detrimental organizational practices survive in the world of business just like viruses survive in nature. Yes, a virus lowers the fitness and life expectancy of the people that embody it but – unfortunately – this does not mean the detrimental virus dies out. That is because many things determine the “fitness” and survival of a particular virus, and the survival of the host (the infected organism) is only one of them. Management practices work much the same way; like viruses, they have fitness levels of their own.

Of course I realize there are major differences between viruses and management practices. For one, unlike viruses, companies can choose whether or not to adopt a particular practice or strategy. Moreover, even if our firm has inadvertently adopted a harmful practice, once we experience its detrimental consequences, we can stop using it. Yet, all that this means is that there are a few basic conditions that have to be present – three in total – for business practices to operate (and survive) like viruses.

Three conditions that help bad practices survive

The first one is that managers must erroneously believe a particular practice is a good one. One way in which this can happen is because the practice has clear benefits in the short-term (while the bigger negative consequences only appear in the long run). Process management systems such as ISO9000, for example, are known to lead to short-term benefits while their negative consequences (of reduced innovation) only materialize in the long-term. Similarly, practices such as outsourcing and downsizing often have short-term benefits but also long-term harmful effects.

Another common reason why managers may believe a practice is good while it isn’t, is because it had positive effects in the past, but now that business circumstances have gradually changed we just continue with the practice, even though it has (unwittingly) become harmful. I often hear executives proclaim – when I query them about a certain process – “that’s just how we have always done it”.

The second condition that helps bad practices survive is “causal ambiguity”: in the long-term, many factors influence a firm’s performance and in complex ways and, even when a company is experiencing bad performance, managers are not quite sure what is driving it. Consequently, they may still not understand that a particular practice – which they might have adopted years ago – is detrimental. And therefore they continue using it. I saw this clearly in the IVF (in-vitro fertilization) industry in the UK, where a popular practice of selecting relatively easy patients to treat led companies to under-perform in the long-term, yet clinics continued using it, unable to understand that the practice (which they had adopted several years earlier) was the cause of their ailments.

The third and final key condition is that the practice “spreads quicker than it kills” – just like a virus. It may gradually reduce the survival chances of the organization that has adopted it, but because it is imitated by someone else before the firm fails, the practice survives. Indeed, harmful practices are easily imitated and adopted – like ISO9000; outsourcing; and downsizing – not seldom with the help of “third-party carriers”, such as consultants, directors or auditors. Much academic research has shown how management practices spread through “contagion”: firms and industry entrants adopt and persist with the practices they see others use as well.

Under these circumstances, even in the most competitive industries, harmful practices and strategies need not die out. In fact, having studied these processes for years, I have no doubt that every organization and every industry has “bad habits”: long-standing management practices that firms and whole industries would be better off without.